Patent valuation: connecting tech differentiation to patent claims

The following simplistic – but often erroneous – equation has been known to mislead valuers and investors:

Highly differentiated technology with strong market potential + patent protection = high patent value

A recent patent valuation highlights the need to link the first two factors in this equation before deciding on the answer. In other words, there should be a clear line of sight between patent claims, technology benefits and valuation assumptions. This is not just an issue for valuers. Without this visibility, there is a risk of poor portfolio management and investment decisions.

A recent example involved a company that had patents on its balance sheet as a result of a corporate acquisition. Financial reporting standards required an impairment review, as changes in the company’s share price indicated a risk that the fair value of the patents had dropped below their carrying value. The resulting valuation revealed that the company had initially struggled to link the patent claims with specific aspects of the manufacturing process and products.

The valuation implications were potentially significant. The company intended to monetise the patents by protecting the differentiating features of its processes and products. So the links between the patents and the drivers of efficiency and demand were fundamental to their expected economic contribution.

Fortunately, in this case collaboration between the valuer, the patent attorney and the client’s technical staff established the connection between the patents and technology. A robust valuation was completed and financial reporting requirements were satisfied (with only a modest write-down in patent value).

This particular case highlights a weakness and a benefit of IP valuation – the weakness being that the capitalised patents had previously been valued, but the appraisal had not explored their functional and economic characteristics. Apparently, the dodgy equation at the start of this article was held to be true. This illustrates how a superficial patent valuation can easily become divorced from commercial reality. Although this is true of other asset categories, the risk is accentuated by the commercial complexity of patents. The benefit flowing from the example is that a comprehensive valuation not only results in a defensible valuation, but also provides useful insights to IP strategy.

Uncertainty regarding patent claims and technology features is not uncommon. How does the situation arise? In large enterprises it can be due to the barriers between the functional silos of R&D, IP management, business development and corporate strategy. Even where there is collaboration between these areas, patent prosecution and tech development can result in gaps between actual and perceived patent coverage. Patent applications are typically made early in the development process. Subsequent development can result in the end technology differing from the initial concept. Moving in the opposite direction, claims in initial patent applications might be narrowed as prior art is identified. This can limit the scope of protection conferred by the patent and, in extreme examples, result in the patent not protecting the end technology.

In small and medium-sized enterprises, similar problems can simply arise because of a lack of IP knowledge or poor communication between the patent owner and attorney.

Portfolio management: linking patents to technology and market performance
The following diagram illustrates the economic importance generated by the features of a (hypothetical) technology that is still in development. The crosses identify which features are covered by a patent.

Once estimates have been made of the importance of the technology’s features, the implications on an IP portfolio are fairly obvious:

• Is there confidence that Patent 1 adequately protects the primary value driver of the technology? What are the design-around risks? Are there supporting trade secrets or other patent opportunities to bolster protection?
• Patent 2 protects a relatively undifferentiated aspect of the technology. Should it be abandoned? Alternatively, if the reason that this feature is not unique is that competitors are infringing, this will open other monetisation opportunities.
• How can Feature D (and, to a lesser extent, Feature E) best be protected?

Gauging the economic importance of components of products and processes can be difficult. The illustration below suggests that this is best done in two steps. 

Step 1 starts at the right-hand side: the source of cash flow. The impact of the technology on cost savings can generally be assessed through engineering studies, laboratory analysis or simulation modelling. It can be trickier to measure the impact of product features on demand, but in some instances this can be quantified through trade-off analysis or econometric modelling. Step 2 moves to the left-hand side of the chart: linking features of the technology back to specific patent claims (or trade secrets) might require input from a patent attorney and technical specialist. Bear in mind that the technology and its relative utility will change over time.

There are as many perspectives to this analysis as there are uses and users of the intellectual property. Value derived from licensing or litigation will relate to the demand and efficiency impact of the patents to other parties.

Valuation implications
Just as a value lens improves portfolio management, a technical lens improves IP valuations. However, it is beyond the scope of some valuations to include patent due diligence. The depth of valuations covers a spectrum ranging from indicative to full-scope valuations. At the start of a valuation engagement it is essential that the briefing party and valuer agree on any limitations in scope. Once the analysis has been completed, the resulting report should clearly identify any scope limitations and factual assumptions on which the opinion is based.

On the other hand, a full-scope valuation should assess the functional, legal and economic characteristics of the subject asset. Before undertaking a valuation of complex intellectual property, the valuer should consider whether it is competent to carry out all relevant analysis or whether specialist opinion is required.